Controlled Group Analysis Is the Key to Complying with Benefits Rules
In today's business world, companies may be owned by entities that also have an interest in
other companies. Business owners may partner with
investors on ventures without knowing about all of their
partners' business holdings. If the parties sponsor
employee benefits plans, there may be "controlled
group" implications that result in penalties -- or even
disqualification of the plans.
Under federal law, related companies and organizations
are treated as a single group for certain employee
benefit purposes. In other words, a business with 20
employees may be treated as having 60 employees if it
is related to another company with 40 employees.
Specific plan requirements that apply to a "controlled
group" include:








Non-discrimination rules under Internal Revenue Code Section 401(a)(4) ;
Actual deferral percentage test (ADP) under Section 401(k);
Actual contribution percentage test (ACP) under Section 401(m);
Deduction rules under Section, 404(a) ;
Coverage testing under Section §410(b);
Vesting requirements under Section 411;
Contribution limits under Section 415; and
Top heavy rules under Section 416.
Controlled group rules are also applicable in the welfare plan arena. An issue of immediate
concern for small employers is the Patient Protection and Affordable Care Act's (ACA) coverage
mandates. Beginning in 2014, an employer with more than 50 full-time equivalent employees will
face a penalty if it does not provide adequate healthcare benefits to full-time employees. Some
employers are assuming they will not be subject to the ACA's coverage mandates, when they
may be under the controlled group rules.
Here is a rundown on the three categories of controlled groups.
1. Parent-Subsidiary Relationship
According to the IRS, a parent-subsidiary controlled group exists when one or more chains of
corporations are connected through stock ownership with a common parent corporation; and


80 percent of the stock of each corporation, (except the common parent) is owned by one
or more corporations in the group; and
The parent corporation must own at least 80 percent of at least one other corporation.
If one of the corporations owned at least an 80 percent profit interest in a partnership, the
employees of that partnership would also be aggregated with the other controlled group
corporations.
2. Brother-Sister Groups
As explained by the IRS, a brother-sister controlled group is a group of two or more corporations,
in which five or fewer common owners (a common owner must be an individual, a trust, or an
estate) collectively own -- directly or indirectly -- a controlling interest of each group and have
"effective control." Effective control requires collective ownership of more than 50 percent of the
stock of each corporation, but only to the extent such stock ownership is identical with respect to
each corporation.
For example, if a shareholder of A and B corporations owned 80 percent of the stock in A, and 20
percent in B, only 20 percent of that shareholder's ownership in A would be counted in this test.
3. Combined Groups
Combined groups are three or more organizations in which:


Each organization is a member of either a parent-subsidiary or brother- sister group; and
At least one corporation is the common parent of a parent-subsidiary and is also a
member of a brother-sister group
(A full detailed description of the controlled group rules by the IRS and illustrations of how they
work is available here.)
Determining stock ownership (or interests in trusts, estates, partnerships and sole
proprietorships) to assess controlled group status is complicated, thanks to "attribution rules."
These rules treat a person "as owning an interest in a business that is not actually owned by that
person," according to the IRS. "Attribution may result from family or business relationships."
In the case of family relationships, that generally means that stock held by a parent, minor child or
a spouse can be attributed to a single individual.
Determining Ownership Stakes
When different classes of stock are involved, the actual value of stock used to determine
ownership interests for controlled group purposes must be assessed based on such factors as
voting, dividend and liquidation rights.
Keep in mind there may be steps an entity can take to revamp a business so it is not treated as
part of the group. This is a highly complex area of federal law. Consult with your tax adviser and
attorney to ensure your organization is in compliance with the rules.
Also, there is a procedure under Internal Revenue Code §414(r) that allows companies to petition
the IRS to separate entities from a controlled group on the basis that they are distinct lines of
business. This may be a cumbersome process and restrictions apply. Among them, each entity
must have at least 50 employees and there must be a valid business purpose for the request.
Also, there are restrictions on permissible highly compensated employee ratios for discrimination
testing purposes under this arrangement.
A good time to assess your status under the controlled group rules and their implications for
employee benefit plans is before entering into a transaction with another business. But even after
the fact, it is important to determine whether you are affected by the controlled group rules.
How to Pay Retiree Health Costs Tax-Free
If you own a small business, you may have set up a defined benefit pension plan for you and
your employees that will provide a specific amount of retirement income based on salary history
and years of service. For 2013, the maximum annual benefit of a defined pension plan is
$205,000 (up from $200,000 in 2012). In future years, it will be subject to cost-of-living
adjustments.
Main Requirements
To qualify for tax-free treatment, a 401(h) plan:







Cannot favor officers, shareholders,
managers or highly compensated
employees in coverage, contributions and
benefits.
Must specify the medical benefits that will
be available and contain provisions for
determining amounts that will be paid. The
benefits, when added to any life insurance
protection provided under the defined
benefit plan, must be subordinate to pension benefits provided by the plan.
Must be financed through a separate account. However the plan can invest the
contributions to the 401(h) account in the same manner it invests money for
retirement benefits.
Must designate the portion of the contributions allocated to financing medical benefits
and the amounts must be reasonable and ascertainable.
Cannot be used for any purpose other than providing medical benefits, although
some funds from the plan can be used to pay necessary or appropriate account
administration expenses.
Must return to the employer any funds remaining in the account after all liabilities
related to operating the plan are satisfied.
Provide that if an individual's interest in the medical benefits account is forfeited
before termination of the plan, an amount equal to the forfeited amount is applied as
soon as possible to reduce employer contributions to finance the medical benefits.
But retirement tends to be a time when medical expenses grow. Those expenses could dilute
your pension with little or no tax benefit.
Medical expenses are currently deductible only to the extent that their annual total exceeds 10
percent of your adjusted gross income (AGI) in 2013 (up from 7.5 percent in 2012). So, if your
annual retirement AGI is $150,000 and your unreimbursed medical expenses total $12,000, you
are out of luck for tax purposes. You can't deduct any of those costs because they don't
exceed 10 percent of your AGI or $15,00. Note: if you or your spouse is age 65 at year end, the
new 10 percent threshold does not take effect until 2017.0
The problem is exacerbated as healthcare costs continue to rise as you get older. What's more,
the threshold is scheduled to increase to 10 percent of your AGI, beginning in 2013.
There is, however, a little-known way to derive some tax benefits. By supplementing your defined
benefit arrangement with a 401(h) plan, you (and your employees) can pay medical expenses
with tax-free distributions. This enables you to maximize the tax efficiency of your plan
contributions and earnings.
Basic Premise
A 401(h) plan provides incidental health benefits to retired employees, their spouses and
dependents. It can cover sickness, accident, hospitalization and other medical expenses provided
the costs don't exceed 25 percent of the employer's total contributions to the defined benefit plan.
The plan must also meet other tax law requirements (see right-hand box).
When you use the funds in the 401(h) account to pay for qualified medical expenses, distributions
are tax free, which could generate substantial future tax savings.
Example
You own a business with a small full-time staff. You have been financing your defined benefit plan
with $50,000 of annual contributions (in addition to the required contributions for other
employees). During the ten years before you retire, you allocate $10,000 of your annual
contributions to a 401(h) account. All of the funds are invested in the same manner.
For simplicity, let's assume you incur $10,000 in unreimbursed medical expenses in each of your
first five years of retirement and you are in the 35 percent tax bracket. You can withdraw $50,000
tax-free to pay for the expenses, saving $17,500 (35 percent of $50,000 annually in taxes). You
can invest the tax savings outside the plan and earn additional income.
This is a complex arrangement that requires the services of an employee benefits tax specialist.
Seek guidance if you think a 401(h) plan may be appropriate for your business.
Tax Planning for a Home in the Event of Divorce
For many people, the federal home sale gain exclusion is the single most valuable tax break
available. But if you're getting divorced and selling a home, you may need to plan ahead to take
advantage of the tax break. We'll explain why, but first, here's a little background information.
Gain Exclusion Basics
If you're unmarried, you can potentially sell a principal residence for a profit of up to $250,000
without owing any federal tax to the U.S.
Treasury. If you're married and file jointly for the
year of sale, you can potentially exclude up to
$500,000 of gain. To qualify, you generally must
pass both of the following tests:
1. You must have owned the property for at least
two years during the five-year period ending on
the sale date (referred to as the ownership test).
2. You must have used the property as a
principal residence for at least two years during
the same five-year period (referred to as the use
test).
To be eligible for the $500,000 joint-filer
exclusion, at least one spouse must pass the
ownership test and both spouses must pass the
use test.
Q. If I take the
exclusion of capital
gain tax on the
sale of my home
this year, can I
also take the
exclusion again if I
sell another home
in the future?
A. Yes. With the exception of the two-year
waiting period, there is no limit on the
number of times you can exclude the gain
on the sale of a principal residence, as
long as you meet the ownership and use
tests.
If you excluded a gain from an earlier principal residence sale under these rules, you generally
must wait at least two years before taking advantage of the tax break again. The $500,000 joint
filer exclusion is only available when both spouses have not claimed an exclusion for an earlier
sale within two years of the sale date in question.
Of course, home sales often occur in divorce situations and the cash from this tax break can
come in handy.
Selling Before a Divorce is Final
Here's how the preceding qualification rules affect homeowners getting a divorce and selling a
home. Let's say a soon-to-be-divorced couple sells their principal residence. Assume they are still
legally married as of the end of the year of sale because their divorce is not yet final. In this
scenario, the splitting couple can shelter up to $500,000 of home sale profit in two different ways:
First, the couple could file a joint return for the year of sale. Provided they meet the basic home
sale gain exclusion timing requirements, they can claim the maximum $500,000 exclusion on
their joint return.
Alternatively, the couple could file separate returns for the year of sale, using married filing
separate status. Assuming the home is owned jointly as community property, each spouse can
then exclude up to $250,000 worth of gain on his or her separate return. To qualify for two
separate $250,000 exclusions, the spouses must each meet the ownership test for their shares of
the property and meet the use test. In most cases, the preceding favorable rules allow a divorcing
couple to convert their home equity into federal-income-tax-free cash. The parties can generally
divide up that cash any way they choose without any further federal tax consequences and go
their separate ways.
Selling in the Year of Divorce or Later
When a couple is divorced as of the end of the year their principal residence is sold, the tax law
considers them divorced for the entire year. Therefore, they are unable to file jointly for the year
of sale. Of course, the same is true when the sale occurs after the year of divorce.
Let's say you wind up with sole ownership of the residence, which was formerly owned by your
ex-spouse. In this case, you are allowed to count your former spouse's period of ownership for
purposes of passing the two-out-of-five-years ownership test when you eventually sell the
property. Your maximum gain exclusion will be $250,000, because you are now single. However,
if you remarry and live in the home with a new spouse for at least two years before selling, you
can qualify for the larger $500,000 joint return exclusion.
Now let's say you end up owning some percentage of the home, while your ex-spouse owns the
rest. When the home is later sold, both you and your ex-spouse can exclude $250,000 of your
respective shares of the gain, provided that you each meet the ownership and use tests.
When a home is sold soon after a divorce, both ex-spouses typically qualify for separate
$250,000 exclusions. However, when the property remains unsold for some time, the ex-spouse
who no longer resides there will eventually fail the two-out-of-five-year use test and become
ineligible for the gain exclusion privilege - unless certain steps are taken.
When a "Nonresident Ex-Spouse" Continues Owning a Home Long After a
Divorce
In many cases, the ex-spouses continue to co-own a former marital home for a long period after
the divorce. Obviously, however, only one ex-spouse continues to live in the home. The problem:
After three years of being out of the house, the "nonresident ex-spouse" will fail the two-out-offive-year use test. That means when the home is finally sold, that person's share of the gain will
be fully taxable. However, this undesirable outcome can be easily prevented with some advance
planning.
Specifically, the divorce papers should stipulate that, as a condition of the divorce
agreement, one ex-spouse is allowed to continue occupying the home for an agreed-upon period
of time (for example, until the kids reach a certain age). At that point, the home can either be put
up for sale with the proceeds split according to the divorce property settlement, or one spouse
can buy out the other's share for its current fair market value.
This arrangement allows the nonresident ex-spouse to receive "credit" for the other party's
continued use of the property as a principal residence. So when the home is finally sold, the
nonresident ex-spouse still passes the use test and thereby qualifies for the $250,000 gain
exclusion privilege.
The same strategy works if you are the nonresident ex-spouse and wind up with complete
ownership of the home, while your ex-spouse continues to live there. Making your ex-spouse's
continued residence in the home a condition of the divorce agreement ensures that you (the
nonresident ex-spouse) will qualify for the $250,000 gain exclusion when the home is eventually
sold.
Conclusion: Getting divorced involves enough financial stress without incurring needless tax
liabilities. With proper planning, you can preserve your right to take advantage of the tax-saving
home sale gain exclusion privilege.